Irrevocable Life Insurance Trusts

Almost everyone has life insurance of some sort. The reasons for owning life insurance are varied. Income protection is probably the most common, but life insurance may also be utilized to fund buy/sell arrangements for the owners of closely held companies, or to provide liquidity so that family businesses or other assets do not have to be liquidated to pay estate taxes.

Most people are aware that the proceeds from a life insurance policy are not subject to federal income tax. But many are unaware that if a decedent has "incidents of ownership" (e.g., owns the policy, or has the power to change the beneficiary, cancel, surrender, assign, pledge or borrow against the policy) the entire proceeds will be included in his or her estate for federal estate tax purposes, and potentially subject to tax at a rate of close to 50%. If the surviving spouse is the beneficiary, the marital deduction will shelter the proceeds at the first death, but whatever remains will be taxed in the survivor's estate.

A properly drafted irrevocable life insurance trust (ILIT) can eliminate the estate tax on the proceeds for both the insured and his or her spouse. It can be useful for modest, as well as large estates. If desirable, the surviving spouse can have an income interest in the proceeds, thereby deriving an economic benefit without any estate tax.

A detailed technical discussion of the ILIT is beyond the scope of this summary. The interplay of the income, gift and estate tax rules is complex. In most cases, the complexities present only housekeeping problems which can be handled with skillful drafting. Keep in mind, however, that in many situations the draftsman must be creative as well as skillful, and the ILIT is not universally suitable.

The most rudimentary characteristics of the ILIT are that: (1) the trust must be irrevocable, and (2) the trust must be the owner and the beneficiary of the life insurance policy. The grantor (or grantors) of the trust may not retain the power to modify or terminate the trust, and should not have the power to change trustees. However, flexibility can be built into the trust by giving certain discretionary powers to the trustee or an independent third party. If possible, the trustee should apply for and acquire the policy. If a current policy is being transferred to the trust, the proceeds will be taxed in the insured's estate if he or she dies within three years of the transfer.

The value of any policy transferred to the trust, and the annual premium payments, constitute gifts by the donor. The annual gift tax exclusion, which is currently 11,000 for 2004 and is indexed for inflation, applies only to present interest gifts, not future interests such as the death benefits from life insurance. In order to qualify these gifts as present interests (to utilize the annual exclusion) the ILIT must provide the trust beneficiaries with the right to withdraw amounts transferred into the trust for a period of time, after which the right lapses. These withdrawal rights are called "Crummey" powers. (Crummey is the name of the taxpayer who prevailed in litigation wherein the present interest exclusion was deemed to apply if a beneficiary has an immediate right to withdraw from trust principal.) This utilization of the annual exclusion should be coordinated with other gifting programs since it will reduce the available exclusion for other gifts to the trust beneficiaries.

The ILIT must designate enough beneficiaries with Crummey powers to cover the value of gifts made to the trust, whether an initial policy transfer or annual premium payments. Minor beneficiaries may be used if a parent or guardian can exercise the power on their behalf. Care must be taken to assure that the Crummey powers are not granted to too broad a class of beneficiaries. The beneficiaries must be notified of their power to withdraw.

When the power lapses, the person holding the power is deemed to have made a future interest gift if the value of the power lapsing in any calendar year exceeds the greater of $5,000 or 5% of the value of trust assets. Therefore, most ILITs provide that the Crummey power not exceed $5,000 for any year. If $5,000 times the number of Crummey power holders is insufficient to cover the amount of the gifts, a hanging power may be used, where the power lapses annually up to the $5,000 or 5% limit, and any excess "hangs" and is accumulated with the incremental power granted for the next year. This can be effective where the value of the initial transfer is too high but future premiums will be below the $5,000 per beneficiary amount, or where premiums are high, but the policy will be fully paid up in a relatively short period of time.

Hanging powers should be used with care. If a beneficiary dies before all of the hanging powers lapse, the beneficiary's unlapsed portion will be included in his or her estate as a general power of appointment. Therefore, the age and health of potential Crummey power holders should be considered if hanging powers are to be utilized.

The administration of an ILIT can be cumbersome. To assure that the Crummey power is not illusory, it is desirable to have the trustee actually hold the funds provided for premium payments for a period of time after the annual Crummey notices are sent to the beneficiaries. This provides a window during which the beneficiaries could exercise their powers in respect to the annual gifts. Group term insurance which has been assigned to an ILIT presents some problems. It may be difficult to determine an employee's portion of the employer paid premiums. Premiums may be paid monthly, and are not likely available for any beneficiary exercising his or her power. In such cases it is a good idea to make sure that the Crummey power extends to the policy itself, and a waiver approach is often used in conjunction with the notice requirements. Another issue presented by term insurance concerns the three year time period (referred to above) during which the proceeds from a transferred policy may be included in the transferor's estate. However, if the policy is renewable without underwriting, and the insurance identical from year to year, renewals are not deemed to be new policies, and the three year time period is not restarted.

An ILIT is an effective means of preserving family wealth by sheltering the proceeds from the estate tax of both spouses. Trust income and principal may be used for the benefit of the survivor, if necessary, or may be for the benefit of younger generations.